Portfolio Ideas. Don’t ask for the moon

Do you spend significant time searching for the best-performing investment products in the market? If so, how do you select them, given that past performance is not necessarily an indicator for the future? This article explains why savings discipline is more important than selecting best-performing schemes or funds.

When you are searching for best-performing investment products, you are essentially looking for managers who generate consistent alpha. Alpha is the excess returns over an appropriate benchmark index. But there are some reasons why your search may be frustrating.

First, alpha is elusive. By this, we mean that portfolio managers do not consistently generate alpha. For one, alpha strategies continually fade because competition from peer funds typically takes away any advantage an alpha-generating portfolio manager has. Next, while there will always be some alpha-generating managers, it is not easy to find them. The reason is that a portfolio manager can generate alpha either through luck or skill, and it is difficult to separate the two.

Second, a substantial proportion of any portfolio’s return is driven by the market, not the alpha. You can look at a mutual fund’s beta and r-squared in the factsheet to confirm this statement. A beta close to one indicates that the fund is driven primarily by market (index) movement; higher the r-squared, more reliable the beta.

Now, market movement is not necessarily predictable. So, even if you buy the best-performing investment products, you could end up losing significant portfolio value due to a global crisis or a country-specific market crash just five years before, say, your retirement.

There are several reasons why disciplined savings are more important for achieving your life goals.

First, would you want to risk not achieving your top-priority goals due to poor portfolio performance? Alpha-generating products can generate higher returns. But they also expose you to the risk of poor performance, as the process of alpha generation is associated with higher-than-market risk.

So, when it comes to your top-priority goals, disciplined savings invested primarily in stable return products such as bank fixed deposits along with some index funds are more helpful.

Second, what will you do when your existing portfolio generates returns that are lower than that required to achieve your life goals? Investing in alpha-generating products could further increase your risk of widening the gap. An alpha-generating fund deviates from its benchmark index to generate higher returns. If the fund’s bets turn wrong, your investment will underperform the benchmark index.

On the other hand, disciplined savings with pre-determined rules to save more every year by systematically setting aside a larger proportion of your annual salary increase could help bridge the gap.

And, finally, if you were to start saving later in your career, a significant proportion of your wealth at retirement will come from your investment capital, not from your portfolio’s returns. So, a disciplined approach to savings becomes more important than buying alpha-generating products.

Disciplined savings and seeking alpha-generating products usually don’t go together. Disciplined savings require a mechanical investment process; systematic investments in mutual funds for instance.

But if you are always seeking alpha-generating products, you may have to continually switch among funds. Then, there is the feeling of regret — choosing a fund that generates lower or even negative alpha.

Setting up systematic investments on index funds and earning average returns may help you suffer less regret.

The writer is the founder of Navera Consulting. Feedback may be sent to portfolioideas@thehindu.co.in

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